Economist, Telegraph Columnist, Broadcaster

Banking Reform is still unfinished business

Early last week, the financial headlines were dominated by the trials and tribulations of a man called Paul Flowers. Later, the news flow switched, as the Bank of England and Treasury modified the controversial Funding for Lending scheme. The story of Flowers, the former Chairman of the Co-op bank, could have some bearing on the future of the UK banking industry. The government’s move to cool the UK’s rocketing mortgage market is also pretty important.

Yet, when it comes to this country’s future trajectory, both episodes pale into insignificance when compared to a little-noticed debate in the House of Lords. The government’s banking bill, debated by peers last week, is this country’s main response to the sub-prime crisis. Whether or not we avoid another cataclysmic financial collapse, with all the related economic fall-out and human misery, depends largely on the measures in that bill.

It’s deeply regrettable, then, that last week’s Lords debate, and its implications, generated little mainstream media coverage. The less public attention there is on such issues, the less pressure on ministers to stand up to the UK’s relentless and deeply self-serving banking lobby. If the bankers gets their way, and they generally do, we’ll have weaker regulation and, in turn, a far higher chance of an early repeat of the ghastly turmoil of late 2008.

The Reverend Paul Flowers, we recently learnt, was filmed allegedly paying £300 for cocaine and discussing the use other illegal drugs. The former Methodist minister had previously humiliated himself before a Parliamentary committee, showing little financial acumen after his bank almost collapsed with £700m of losses.

Last week, the Flowers saga developed, with the Treasury announcing an “independent inquiry into events at the Co-op”. Meanwhile, two men were arrested as part of a “drugs supply investigation” as Flowers explained his behavior by citing the death of his mother.

The Co-op, with its 600,000 customers and thousands of staff, is a well-known bank with a long and proud history. While not large enough to be systemically significant, it could yet collapse – a far cry from its recent ambition to annex over 600 branches from Lloyds and double in size.

Yet the fate of the Co-op, and its bearing on the future of the UK’s broader banking industry, isn’t what sparked media interest. It was, of course, the “Crystal Methodist’s” Labour affiliation, his former bank’s closeness to the party and, above all, the eye-catching nature of his alleged peccadillos that have driven the recent publicity frenzy.

Last Thursday, news emerged that from January 2014 the government will cease propping-up cheap mortgages. The Funding for Lending scheme was designed to encourage both mortgage lending and the extension of business credit.

Since July 2012, FLS has allowed banks to borrow close to £20bn from the Bank of England at interest rates as low as 0.75pc. This has driven mortgage rates downward and boosted home loan activity. Mortgage approvals this year have been 30pc up on 2010 and 2011. Last month, they hit their highest level since February 2008, as 67,701 home loans were dished-out worth £10.5bn, compared to £10.1bn the month before.

House prices have soared as a result of FLS, up 6.8pc in October on average compared to the same month in 2012, with much of the rise in the South East. That’s led to concerns of a dangerous housing bubble and unsustainable consumer indebtedness. Total household debt just hit a record-high of £1,430bn, eclipsing pre-crisis levels despite low wage growth.

Reining-in FLS mortgage lending makes sense. The housing market is flashing red, given a demand surge that far out-strips the still paltry growth in supply. Home completions totaled just 107,950 over the 12 months to September, down 8pc on the year before. It’s dangerous, despite the short-term sugar rush, to boosting mortgage lending when the supply of homes is so tight.

Cheap FLS finance has also made banks far less reliant on consumer deposits. That’s helped drive savings rates well below inflation – hitting those, not least the elderly, who rely in part on savings interest. It’s good news, too, that FLS will now focus only on business lending. Banks will still be able to borrow at rock-bottom rates from the Bank of England, but only if they use the funds to boost loans to small and medium-sized enterprises.

Net business lending fell £1.1bn in October, compared to the same month in 2012. SME loans were £500m lower over the month, down 3.1pc on the year before. If FLS can help channel finance to creditworthy SMEs, it could yet help drive commercial investment, so contributing to a meaningful recovery.

Many worry that the demise of FLS mortgage finance marks the beginning of the end of ultra-cheap home loans – something debt-stretched households won’t welcome. But if this move prevents an alarming housing bubble, it may be that the Bank of England ultimately waits longer before finally raising the base rate from its current abnormal low.

Beyond all the high-profile coverage of Flowers and FLS, the government’s banking bill was last week debated in the Lords. For months, members of the Parliamentary Commission on Banking Standards, led by Andrew Tyrie MP, with strong support from Lord Lawson, Labour’s Lord McFall and Justin Welby, the Archbishop of Canterbury, have been fighting against the odds to try to make sure the bill the kind of structural reforms that make our financial services industry safer and less likely to demand yet another ruinous bail-out.
Largely as a result of the Commission’s efforts, the Treasury last week gave some ground. Bankers could now be subject to a tough new licensing regime and professional conduct requirements – an issue that Flowers has brought into focus. There will also be a review into the possibility of banning “proprietary trading” – when banks trade with their own resources, so risk their stability.

Prior to the debate, the Treasury also said it had instructed the Bank of England to look at the issue of leverage ratios – the size of each bank’s loss-absorbing capital compared to its loans and investments. Governor Mark Carney has argued that tight ratios during the early part of this century helped ensure banks in his native Canada didn’t blow-up in 2008, as they did here in the UK. Chancellor Osborne conceded that a binding ratio, higher than the 3pc international minimum, could be imposed on British banks earlier than the current 2018 target – but he wants a year-long Bank of England review.

These compromises have been hard won. The PCBS members who helped secure them deserve our gratitude and praise. And yet, they all amount to possibilities, maybes and unknowns. They could result in no changes at all – and they’re almost certain to do so, given the banking lobby’s political clout, unless ministers come under enormous public pressure to impose the changes the moneymen don’t want.

Early in the debate, the government rejected an attempt to include in the bill the prospect of a full Glass-Steagall split between the UK’s commercial and investment banks. For my money, and that of a very broad range of expert opinion, this clear separation is the most crucial reform of all, if we’re to solve “too-big-to-fail”, and defuse a UK banking sector five times larger than our economy and now even more concentrated that it was prior to the sub-prime collapse.

OK – the Treasury will now allow “an independent review” of whether the proposed “ring-fence” between each banks’ retail and investment arms is working. But how will we know that it isn’t, unless there’s another crash?